U.S. Companies' Sales to EU Consumers Subject to VAT on Digital Downloads

U.S. companies selling digitized goods to individuals (as opposed to businesses) in the European Union (EU) will soon have to collect and remit value-added tax (VAT) to the EU. Currently, U.S. companies are not responsible for accounting for or paying these taxes. This change came about because the EU Economic and Financial Affairs (ECOFIN) Council approved a directive to require non-EU vendors to collect and remit EU VAT on digital goods and services supplied to EU consumers (the Directive). The ECOFIN Council enumerated an illustrative list of digital goods and services that the Directive intends to cover (although it may also include items not on the list), including website supply; web-hosting; distance maintenance of programs and equipment; supply and updating of software; supply of images, text and information and making databases available; supply of music, films and games (including games of chance and gambling games); political, cultural, artistic, sporting, scientific and entertainment broadcasts and events; and the supply of distance teaching. No minimum threshold applies to sales amounts. For VAT registration, each EU member state can adopt its current threshold.

On April 25, 2002, the European Parliament (Parliament) raised procedural objections to the Directive. These objections create an additional procedural requirement that must be met before the Directive can be implemented. If the ECOFIN Council does not object to the findings of the Parliament, the Council will send the Directive to the Parliament for its consideration and (expected) approval. However, if the ECOFIN Council objects to the Parliament's actions, and adopts the Directive in its current form without regard to Parliament's suggestions, Parliament may appeal to the European Court of Justice in Luxembourg for a ruling on the correct interpretation of the procedural rules. In either event, additional procedural actions will need to be taken before the Directive can be approved and implemented in the EU member states.

The Directive requires each member state to change its individual laws to bring them into conformity by July 1, 2003. Note: Despite this, countries can make the change earlier. The requirement to collect and remit EU VAT will expire after three years. However, if the member states unanimously agree, they can extend the law beyond that period.

Issues

U.S. companies have many concerns about the new provision. For example, the Directive does not include a de minimis threshold. The original proposal, issued in May 2000, excluded vendors with minimal EU sales. The new Directive, however, does not. Literally, a vendor with only a dollar of digitized-goods sales in the EU must account for VAT.

Failing to establish a uniform threshold means that each member state can enact its own unique threshold or apply existing thresholds for intra-EU sales. Currently, for EU sales, the threshold varies from zero to approximately 85,000 euros (approximately $75,000). It is not clear how sales-threshold rules will apply to non-EU vendors subject to the "special scheme" set forth in the Directive. For instance, if a non-EU vendor exceeds the sales threshold in one member state, would that vendor be required to register there and then collect VAT for all the member states in which it makes sales? Would a non-EU vendor be permitted to collect and remit VAT only for sales made in a "member state of consumption" if the sale exceeds that member state's thresholds? Will U.S. companies have to set up separate accounting procedures for each country in the EU? All of these issues add complexity, making compliance difficult.

Added to this, the Directive does not provide any safe harbors to help vendors determine the residence of the individual consumer buying goods or services. Under the Directive, a non-EU company must charge VAT based on the customer's location. The vendor would not be protected if the individual consumer provides inaccurate (or fraudulent) information. Absent such protection, the vendor presumably would not be in compliance with the rules if it collects and remits VAT based on information that it received from the customer in good faith. Also, what if there is a discrepancy between a customer's ordering location and his shipping address (e.g., the customer purchases goods via the Internet while on vacation, but has them delivered to his home address)?

Perhaps U.S. companies' primary concern is that the Directive will give them a competitive disadvantage; the U.S. and other non-EU vendors will have to verify purchasers' locations (and other information). A U.S. vendor will have to charge and collect VAT at the rate that applies in the country of consumption. An EU vendor will only have to charge VAT at the rate that applies in the country where the seller is established (subject to exceeding the distance-selling-threshold limits, at which point the EU vendor will be in the same position as a U.S. vendor). The option to account for one country at one VAT rate appears no longer open to U.S. vendors.

Further, this leads to rate discrepancies. Sales of digital goods and services covered by the Directive cannot enjoy the reduced rates that otherwise apply to their tangible equivalents. Put simply, the reduced rates for books, magazines and newspapers physically available in the U.K. and other EU member states do not apply to e-books or to electronic subscriptions to newspapers and magazines provided by non-EU vendors.

The EU has acknowledged these discrepancies, citing the mode of delivery (i.e., electronic) as the principle cause. Beyond a broad commitment to review the problems, the EU has not taken any action to introduce parity when a rate differential exists between goods qualifying for VAT reduced rates and their digital counterparts that do not. As consumers typically expect prices of digital goods to be lower than their physical equivalents, VAT rate differentials represent a real problem for vendors selling digital goods.

Practical Effect

The Directive places significant financial and compliance burdens on U.S. companies selling digitized goods to individuals in EU-member countries. As a result of VAT, if U.S. companies do not raise prices, they will have lower profit margins. Moreover, the compliance burden might prove as expensive as the financial impact per unit sold--companies will have to track customers' locations, become proficient in VAT, and timely file returns (which will differ from member state to member state).

While U.S. vendors have many concerns regarding the Directive, they cannot ignore it. If a company does not comply with the Directive, it could be subject to interest and penalties; civil and criminal sanctions might apply to business managers or owners as well. The member states may even try to shut down websites hosted in their countries.

Conclusion

The Directive places a significant burden on U.S. companies selling digitized goods to individuals located in EU member states. Besides the cost of paying VAT, compliance obligations may prove impossible. As the Directive is rolled out, it will be interesting to see how U.S. companies adapt. They should start to consider the issues now and determine what sort of systems and procedures they will need, as the Directive may be implemented at any time.

From Sarah Fitzgerald, J.D., Washington, DC